Federal Funds Rate

In USA banking system, I come to know how USA banks fulfill their needs overnight ( Just for 12 hours). Actually, all private banks in USA need to keep reserve in local federal reserve bank. When a bank need money for very short period, they can take loan from this bank. Federal reserve bank takes interest with minimum rate. That rate is called federal fund rate.


Importance of Federal Fund Rate

This rate is very useful to control the money supply in USA financial market. Fed Fund rate is not fixed but it is that target rate which is fixed by open market operation committee in USA. For more supply in market, this rate is very low, so loans can get spent, and the proceeds get deposited at other banks. Whatever is not required to be held as reserves is then lent out again, and through the "multiplying" effect of the fractional-reserve system, loans and bank deposits go up by many times the initial injection of reserves.

Prof. Salman Khan's Video Tutorial for Deep Understanding of Fed Funds Rate

Q:- if a bank is below its reserve requirement, how does borrowing overnight from another bank fix that issue. Borrowing increases liabilities as well as assets/reserves so seems to me that the bank hasn't changed it's reserve ratio by doing so.

Ans:- good question. Let's say that I have $95 in reserves and $1000 in checking accounts outstanding (so a 9.5% reserve ratio). I want to be at 10% so if I take in another $50 in reserves and also increase my liabilities by $50, my reserve ratio is now (95+50)/(1000+50) = 13%. I could get those reserves from taking them as deposits or borrowing from another bank (could view it as the other bank making a checking out deposit to get interest on their excess reserves).



Related : Capital Adequacy Ratio